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Should You Use Your Retirement Account to Pay Off Debt?

If you are stuck in a lot of debt, taking money out of your retirement account sounds like an easy fix. But should you do it?
 
Using retirement funds to pay off high-interest credit cards, or outstanding financial obligations, is a common, yet less advised method of managing expenses. Liquidation of a retirement fund often does allow you to fully pay off your accounts owed. However, before making the decision to tap into your retirement savings, or transfer your assets to cash, review the terms and conditions for early withdrawal from a 401(k) or long-term investment.
 

Terms and Conditions for Early Distribution 

 
Traditional and Roth retirement fund accounts, for example, have different terms for early distribution. The former is comprised of pre-tax dollars. Distribution from a traditional retirement fund will lead to taxation of contributions and earnings. Roth retirement accounts are contributed with taxed dollars, so that contributions and earnings are tax-free at time of distribution.
 
The 401(k) retirement plan is typically an employer-sponsored fund. Automatic paycheck contributions provide the basis to this type of retirement account. Individual retirement accounts (IRA) are not employer-sponsored. IRA are available as part of traditional and Roth retirement products. Standard rules to retirement funds stipulate restricted distribution until after the age of 59½ to forego penalties. Taxes and penalties are applied on retirement accounts.
 
Early withdrawal from a 401(k) or IRA will result in tax obligation. Roth accounts are exempt from this rule, due to the payment of taxes on deposit. Standard income tax indices apply to early withdrawal from a 401(k) or IRA. Investors can expect to pay between 10 percent and 39.6 percent, depending on state tax rates. 
 

Rules to 401(k) or IRA Account Penalties

 
Retirement funds are long-term investment assets. If an investor does not allow for maturation of a retirement fund, and those monies are withdrawn prior to age 59½ years, those penalties are, as of 2014, a flat 10% of distributed funds. Roth contributions can be withdrawn without paying taxes or penalties, however, earnings, penalties and taxes are assessed.
 
Exceptions to 401(k) or IRA account penalties: 1) IRAs – transfer of funds to another retirement account; permanent disability; health insurance premium payments while unemployed; college expenses; residential property investment; or medical expenses in excess of 7.5% of adjusted gross income. Although extraneous accounts cannot be met without taxation on early withdrawal, paying off tax owed occludes an investor from new tax payments in the case of 401(k) or IRA funds. 
 

Liquidating Tax-deferred Retirement Assets

 
When reviewing a retirement portfolio for early disbursement, there may be several asset classes from which to draw from. If the funds come from an IRA, 401(k), or other tax-deferred retirement fund, income taxes are imminent. Here is an index rule of thumb to early withdrawal from a retirement fund: 
 
If you withdrawal $10,000 to pay expenses, and are in the IRS 25% income tax bracket, tax liability will be $2,500. 
 
Ratio of cash to tax on early retirement income: 
 
If net $10,000 is required to meet all outstanding debt or expenses, withdraw of $13,333 will be required. 
 
Limitations on age at time of disbursement also matters. 
 
If you are under 59½ years in age, a tax penalty of 10% in addition to standard income tax liability on an early tax-deferred retirement fund distribution will apply to earnings. 
 
Ratio of cash to tax on early retirement income (-59 ½ years of age):
That $10,000 withdrawal will cost $3,500 in fees. 
 
There are a few exceptions to the age rule. Retirement plan holders 55 or older, separated from the originating employer of a 401(k) may be eligible for early withdrawal without penalties. 
 
Other exception in circumstances of death and disability will generally apply. Investors should review their retirement agreement for detailed information about exceptions to the 10% early withdrawal penalty in case of early disbursement from a tax-deferred retirement fund. 
 
If a retirement fund also offers loan resources, this is obviously a way to avoid stiff taxation and penalties on early withdrawal from a retirement fund. A financial advisor can provide more insight into the options for tapping into the liquidity of a retirement fund. There are usually limits to how much an investor can request on a loan. If the retirement fund account balance is high enough, it may be possible for the investor to also repay other outstanding loans. 
 
By assessing your current financial position, calculation of the best possible solution to the equity – debt equation will provide indicators of the right funding strategy. For those investors still employed where an employer is paying in on a 401(k), the distribution may be taxable. 
 

The Impact of Early Withdrawal from Retirement Savings 

 
Once an investor has assessed the overall impact of early withdrawal from retirement savings for paying down expenses, it should be recognized that future earnings will also be affected. The result of early disbursement from an IRA 401(k) or Roth account is that the compound interest that would be earned had the asset remained untouched, will be lost in the process, if those funds are not replacement. 
 
Proportional loss of earnings over time can be risky. Calculating conservative annual returns is the best measure of estimating total earnings lost on a disbursed retirement fund in 10 to 30 years. If retirement funds are not met with new investment, an investor might be giving up five to six figures in funds at minimum. This is a major concession for most investors. Once taxes and penalties are factored into the equation, the costs can be too steep. 
 
Early withdrawal of funds, should then, be the last strategy on the list. Even if outstanding accounts includes credit card interest rates exceeding an investor’s indexed tax rate, the early disbursement strategy is still not the best model of financial management. By exhausting all other possible measures, an investor will know when it is time to tap into a retirement fund. Finding loans or interest free credit cards for transfer of existing accounts owed to a new financial product will alleviate the need to drain a retirement portfolio. Most safe investors retain their retirement fund. 
 

In Conclusion

 
You want to think hard before using your retirement account to pay off debt  The escalation of total sums owed due to interest on accounts owed can cause extensive financial damage. The best approach to managing debt is to seek consultation. Financial advisors trained in the process of reducing consumer debt acknowledge that even careful retirement planners can find themselves in a bind. Before taking monies out an existing IRA, 401(k) or Roth retirement fund, speak to a debt consultant about alternatives to consolidating, or paying off monies owed. Protect your financial well-being with investment advice from a licensed advisor.
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Alice Bryant's picture

Alice Bryant is the Editor of Creditnet and a personal finance expert with over a decade of experience writing about credit cards, credit scores, debt repair, and more.

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